Having a well-diversified portfolio is one of the best ways to protect yourself against loss and risk, and one way to do this is to participate in hedge funds. They are a fundamental part of many investors’ portfolios—but what are they, and what are some things you need to know before you begin investing in them?
What are Hedge Funds?
Hedge funds get a lot of attention from Wall Street, but what are they? They are private investment funds that market themselves almost exclusively to wealthy investors. They can be aggressively managed or use derivatives and leverage in domestic and international markets to generate high returns for investors. Hedge funds also have much less oversight from the Securities and Exchange Commission.
Hedge funds have the promise to produce high profit, but, in exchange, investors have to pay increased fees that cover operational costs and performance fees. Performance fees are when hedge funds do exceptionally well, and the managers take a bit of the profit as a cost.
What are Some Characteristics?
First of all, hedge funds are only open to accredited or qualified investors that have over $1 million in net worth excluding their primary residence. A hedge fund is also not limited by its mandate and can be anything including land, real estate, stocks, and currencies. Many see this type of investment as risky because it uses borrowed money to amplify returns, and, if it doesn’t perform well, the money can be lost.
One of the biggest things that defines hedge funds from any other type of investment is that it doesn’t report to the SEC or any regulatory agency even though the investors are spending quite a bit of money. Sometimes, managers are not transparent with the hedge fund, which can make the investment much riskier, but many still participate because there is always a chance for high returns.
Why Invest in Hedge Funds?
With all this risk, you might ask why would anyone invest in something like a hedge fund? There are plenty of reasons to include them in a portfolio. First of all, it can minimize the risk of losing everything. Hedge funds usually provide returns that increase the stability of a portfolio when other investments are underperforming.
Additionally, hedge funds can improve returns through a low-volatility hedge fund that consistently produces a profit or a high-return strategy for just a little more risk. Global macro, for example, has some of the highest returns in hedge funds because it participates in various equities, fixed incomes, currencies, commodities and future markets.
What are Funds of Funds?
It’s impossible to talk about hedge funds and not mention funds of funds. This type of hedge fund is a variety of hedge funds combined into one, and they generally have lower minimums when compared to individual investments. Fund of funds give an investor instant diversification for their portfolio because they can either invest in a group of different strategies or in single-strategy funds.
However, there are drawbacks to fund of funds, one of which being that the fees are typically higher than the traditional options. Additionally, because this method invests in several different funds at one time, it’s possible that a stockholder who invests in several funds of funds can purchase the same stock or security twice, which can decrease potential diversification.